The Increased Importance of Income Sourcing in a Post-Tax Reform World
The Tax Cuts and Jobs Act of 2017 (TCJA), signed into law in late 2017, included significant changes to the tax environment in the United States. One of the largest changes was the addition of the qualified business income (QBI) deduction. The QBI deduction allows for a deduction of up to 20 percent of the qualified business income from partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships. Learn more about the QBI deduction.
One significant nuance of the QBI deduction involves a rule related to sourcing. Under TCJA, only taxable items of income, gain, deduction, or loss that are effectively connected with the conduct of a trade or business within the U.S. are eligible to be taken into account in the computation of QBI. Therefore, the determination of whether the income, gain, deduction, or loss is U.S. sourced or foreign sourced becomes critically important.
General Income Sourcing Rules
The rules around sourcing are complex and are found in Internal Revenue Code Sections 861-865. Here are some general and common rules on sourcing different types of income:
|Income Source||What Determines Sourcing?|
|Income from personal services||Where services are performed1|
|Interest income||Tax residence of the debtor|
|Rental income||Location of the property|
|Royalty income||Jurisdiction of the underlying intangibles being used by the licensee|
|Gain from the sale of real property||Location of the property|
|Gain from the sale of personal property||Residence of the seller2|
|Gain from the sale of intangible property||Jurisdiction of the underlying intangibles|
|Sale of depreciable property||Where the depreciation deduction was sourced|
|Inventory income and gains produced or manufactured by the taxpayer (for tax years after 2017)||Where production activities are performed|
|Inventory income for property not produced by the taxpayer||Location of the sale (i.e., location of title transfer) regardless of the place of purchase|
|Definitely related deductions||Consistent with the type of income giving rise to such deductions|
|Deductions not definitely related||May be allocated to a gross income class or various gross income classes. These deductions may be further apportioned between “statutory grouping” and “residual grouping” in a manner that best reflects the factual relationship between the deduction and grouping of gross income.|
|Interest expense and research and experimental expenditures
(Note that these are excluded from the methodology of definitely related deductions.)
|Interest expense is generally allocable to all gross income that the assets of the taxpayer generate, typically on the “tax book value” of the assets.
Research and experimental expenditures are generally allocated to the jurisdiction of the activities.
1 If services are provided both inside the U.S. and abroad, the allocation is generally determined using a location-per-day methodology.
2 Exception per IRS Section 865: If the gains for personal property are attributable to a fixed place of business in a foreign country and are subject to at least 10 percent tax, they will be foreign sourced.
Rules for U.S. Residents and Nonresidents
Some additional rules related to sourcing for both U.S. residents and nonresidents have to do with sales through offices or fixed places of business. The QBI rules state that qualified trade or business income must be effectively connected with a U.S. trade or business to determine eligibility for the QBI deduction.
- For U.S. residents who maintain an office or other place of business in a foreign country, and with income that does not qualify for an exception (exceptions are sales of inventory, recovery of depreciation, contingent sales of intangible property, sales of good will, or sales of affiliated foreign stock), sales of personal property attributable to an office or other fixed place of business will be foreign source income. A further requirement to meet the exception is that the income is subject to tax equal to 10 percent and actually paid to a foreign country.
- For nonresidents who maintain an office or fixed place of business in the U.S., income from any sale of personal property (including inventory) attributable to the office shall be U.S. source income. This scenario overrides all the sourcing rules above. The only exception for this rule is if the nonresident sells inventory property for use, disposition, or consumption outside of the U.S. and has an office in a foreign country that materially participated in the sale. However, double taxation treaties may mitigate the U.S. tax impact of this rule. This exception also applies to U.S. persons for purposes of determining the QBI deduction.
The QBI deduction applies at the individual or shareholder level. With respect to partnership and S corporations, the character and source of the income, determined at the entity level, carries over to the partners or shareholders in their distributive share of the flow-through income. However, the sourcing of the underlying income of the partnership or S corporation’s foreign operations will solely depend on the source of income based on the classifications listed above.
Prior to TCJA, taxpayers were typically incentivized to treat as much income as possible as a foreign source to maximize available foreign tax credits as a way to offset residual U.S. income taxation. However, under the new rules, QBI does not generally include foreign source income. As a result, taxpayers may need to revisit the sourcing treatment of income to maximize the QBI deduction. Please reach out to your KSM advisor if you have any additional questions.
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